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Conceptus Inc. (NASDAQ:CPTS)

Q2 2008 Earnings Conference Call

Jul. 23, 2008 4:30 pm ET.

Executives

Kim Golodetz - Lippert/Heilshorn & Associates

Mark Sieczkarek -President and CEO

Greg Lichtwardt- CFO

Analysts

Eli Kammerman - Cowen

Michael Tieu - Oppenheimer

Jonathan Block - SunTrust Robinson

Daniel Mallin - WBB Securities

John Putnam - Dawson James Securities

Jason Bedford - Raymond James

Shawn Fitz - Stephens Incorporated

Thomas Kouchoukos - Northland Securities

Operator

Good afternoon and welcome to the Conceptus Incorporated second quarter conference call. (Operator Instructions)

As a reminder this conference is being recorded July 23, 2008.

I would now like to turn the conference over to Kim Golodetz. Please go ahead, ma'am.

Kim Golodetz

Thank you, this is Kim Golodetz with Lippert/Heilshorn & Associates. Thank you all for participating in today's call. Joining me this afternoon from Conceptus are Mark Sieczkarek, the President and Chief Executive Officer; and Greg Lichtwardt, Chief Financial Officer.

This call will follow the usual format beginning with prepared remarks by management. And then we'll open the call up to your questions. In order to accommodate as many of you as possible, we ask that you limit your questions to one, plus one follow-up before rejoining the queue.

Earlier today, Conceptus issued financial results for the second quarter of 2008. If you have not received this news release or if you would like to be added to the company's distribution list, please call Lippert/Heilshorn in New York at 212-838-3777 and speak with Cheryl Pillotso.

Before we begin, I would like to caution that comments made during this conference call by management will contain forward-looking statements involving the operations and future results of Conceptus that involve risks and uncertainties. I encourage you to review the company's filings with the Securities and Exchange Commission, including, without limitation, the company's Form 10-K and Forms 10-Q, which identify specific factors that may cause actual results or events to differ materially from those described in the forward-looking statements.

These factors include strategic planning decisions by management, reallocation of internal resources, decisions by public and private sector payers, scientific advances by third-parties, and introduction of competitive products among others. Importantly, the content of this conference call contains time sensitive information that is accurate only as of the date of the live call, today, July 23, 2008. The company undertakes no obligation to revise or update any statements to reflect events or circumstances after the date of this conference call.

With that said, I would like to turn the call over to Mark Sieczkarek. Mark?

Mark Sieczkarek

Thanks, Kim, and good afternoon, everyone. Thanks for joining us. In our prepared remarks today, Greg and I will discuss the financial performance of Conceptus for the second quarter, guidance for the remainder of the year, and then I'm going to update you on the progress we are making in our direct-to-consumer program and some other goals for 2008. And after that, we'll of course take your questions.

So let me start with the discussion about our second quarter financial results, and steal some of the thunder before turning the call over to Greg. Our second quarter net sales increased 64% year-over-year, up sharply from the 53% growth that we reported in the first quarter. Now, while this result includes the higher growth rates resulting from our acquisition of Conceptus SAS, it also represents solid domestic growth of 43%, which is certainly a notable uptake from the first quarter growth of 31%.

Now this improvement, as expected, validated what we expected to be true, and that is, that the first quarter Essure product sales were most impacted by the one-time resetting of medical insurance deductibles, and the resulting consumer deferral non-urgent care procedures like Essure, rather than the overall downturn of the economy.

Now, as was the case with the downturn in the first quarter, the recovery in the second was very broad-based across all consumer channels, and also included an increase in utilization rates to more historical levels. Now the strength in the U.S. business was highlighted by a particularly strong position metrics and the continued strong execution of driving the percentage of sales coming from the office channel which is now over 50%.

And that gives us the confidence in both, the short and long-term direction of our business. In particular, we are reaffirming our ability to break the $100 million mark this year in sales and also profitability in the third and fourth quarter, which represents a significant milestone for our business.

In addition to strong sales performance, we also achieved dramatic reduction in our net loss for the second quarter as a combined result of growth in the sales and a strong gross profit margin. As we reported, the company generated over $3 million of positive cash flow, despite a healthy investment in our direct-to-consumer program.

Additionally, if you include the non-cash 123R expense, Conceptus had positive operating income for the second quarter, and with gross margins now sustainable at 80%, coupled with continued sales growth, we will move the business to after-tax profitability in the third quarter, again, another major milestone.

With that I'm going to ask Greg to comment in more detail on the financial results for second quarter. Greg?

Greg Lichtwardt

Thank you, Mark. Good afternoon, everyone. As I customarily do, I am going to take a few minutes to provide some additional commentary to our financial results for the second quarter, and our financial guidance for the third quarter and full-year as reported in today's press release.

With respect to second quarter net sales, we experienced strong growth in both our domestic and international sales channels, with domestic sales increasing 43% and international sales increasing 232% over the second quarter of last year. Overall, sales of $25.7 million for the quarter, was at the upper end of our guidance range of $25 million to $26 million we gave last quarter. Total sales for the second quarter also represents quarter-to-quarter worldwide net sales growth of approximately 22%.

International net sales, as reported, benefited from the impact of our capture of direct sales, as the result of our acquisition of Conceptus SAS in the first quarter of this year. Comparing international net sales for the second quarter of 2008 to the prior year second quarter based on direct or end-user sales, the actual net sales growth is 48%, which compares favorably with the first quarter year-over-year growth I reported to you of 42%. We remain confident that this channel will finish the year well above our original expectations communicated at the beginning of the year.

On a unit basis, we shipped over 21,800 units, of which the U.S. accounted for 68%, and international for 32%. Domestic average selling prices have remained relatively constant at 1,325, and international ASPs are $826 overall, and $862 in Europe, which is a further increase from the first quarter due mostly to favorable currency translation.

With respect to domestic physician metrics, we see continued strong numbers during the quarter with 560 physicians performing their first preceptored case, 488 physicians becoming certified, and 464 physicians transitioning to the office. At the end of the quarter, we had 3,280 physicians in preceptorship, of which 683 are performing cases in the office.

With respect to certified physicians, we ended the quarter with 2,173 physicians performing in the hospital, and 2,362 physicians performing in the office, representing the first time where in-office certified physicians exceed hospital certified physicians, a remarkable statistic for us.

At the end of the first quarter, 7,815 U.S. total physicians have performed at least one Essure procedure. As you know from previous reports, while the number of physicians entering preceptorship does fluctuate, the latter two metrics of physicians becoming certified and transitioning to the office each represent continuous quarter-to-quarter growth and each are record numbers for the second quarter.

While this is gratifying, each of these metrics is already significantly above our expectations, and we do not believe that this will continue indefinitely. Nonetheless, the significant growth in the numbers of certified physicians, as well as those transitioning to the office continue to be the main drivers of the business, as each of these categories represent higher utilization rates.

Sales from the office channel increased to 51% from 46% in the last two quarters, and from 40% in the prior year second quarter. Overall utilization rates did rebound during the quarter and with continued movement of physicians to the certified and in-office categories, further expansion in this metric is expected.

Turning back to our financial performance for the second quarter of 2008, the second quarter was significant for us, as we reached 80% gross profit margin for quarter, as compared with 73% in the previous year and 74% in the immediately preceding quarter.

The current gross margin now fully reflects the benefits from the higher average selling prices associated with our acquisition of Conceptus SAS, the beneficial impact of foreign currency, as well as production cost reductions related to the third generation device and volume increases.

We expect to be able to maintain or slightly exceed this level of profit margin for the foreseeable future, subject to channel mix and exchange rates. This gross margin is also a key contributor to our ability to achieve profitability in the back half of this year.

Total operating expenses of $21.7 million for the second quarter, in line with our guidance compares with $14.2 million in the previous years second quarter, and a decrease of $300,000 from the previous quarter operating expense level of $22 million.

This year-over-year increase is comprised of several factors; $3 million in patient awareness expenditures dominated by the DTC campaign, $2.2 million for international operating expenses, in part attributable to the acquisition of Conceptus SAS. $1.8 million in U.S. selling expense, primarily associated with the expansion of our sales force, and $600,000 increase in R&D expenses associated with product development in clinicals.

The quarter-to-quarter decline in operating expenses is related to decreases in DTC expenditures, which will decline again in the third quarter as the bolus of planned advertising for 2008 has been completed.

Our net loss for the second quarter of 2008 was $1.6 million as compared to $2.1 million for the prior year second quarter, and a guidance range loss of $0.5 million to $1.5 million. The reported net loss exceeded guidance primarily, due to a shortfall in interest income, as interest rates continued their dramatic decline. In our case, interest earned on our invested capital averaged 2.1% in the second quarter, as compared to 5.7% in the first quarter.

Furthermore, as mentioned in the press release, the portion of our invested capital that is in auction rate securities is currently earning a yield of 500 basis points below straight money market yield which is currently running at about 2.5%.

With respect to the impact of foreign currency since the dollar was generally stronger during the second quarter as compared to the first quarter, we recorded an overall $80,000 currency gain that results more from the transaction effects of our inner company accounts than the impact of the hedge that we discussed in detail last quarter. As the year progresses, this hedge will continue to diminish as we utilize it to pay down intercompany balances until it is fully extinguished by the end of the year.

With respect to the balance sheet, we ended the second quarter with cash of $21.2 million, representing a significant increase of $3 million from the cash balance of $18.2 million at the end of the first quarter. As Mark mentioned in his comments, achieving sustainable positive cash flow from operations marks a huge milestone for us, and we are pleased to have managed to this point in becoming a self-sustaining business.

Worldwide, account receivable day sales outstanding of 46, is down from 52 at the end of the first quarter. U.S. DSO is down to an all time low of 40 days, down from 45 days at the end of the first quarter, reflecting a successful introduction of a pay-by-credit card program put in place mainly for our in-office physicians.

Inventory of $4.7 million increased from $3.7 million at the end of the first quarter, attributable to a planned increase in production at our third-party supplier.

Okay, moving onto financial guidance. As reported in the press release, while we are reaffirming full-year sales guidance of $102 million to $105 million, we are lowering net income guidance for the full-year to $500,000 to $2 million to reflect the shortfall caused by declines in interest income in the non-cash inventory adjustment made in the first quarter in conjunction with the SAS acquisition.

In detail for the third quarter, we are guiding to a net sales of $25 million to $26 million. While this is flat compared to our guidance for the second quarter, it is representative of two offsetting factors.

While domestic growth both year-over-year and quarter-to-quarter is expected consistent with recent trends, international is expected to decline quarter-to-quarter, due to the summer seasonality. Now that we are recording international sales on a direct basis, this reduction is more apparent in total dollars than in previous years when we were recording net sales to the distributor.

For the fourth quarter, this leaves us with a net sales expectation of $30 million to $32 million, although on the surface this appears to be a large increase, from the third quarter expectation, it remains in line with current domestic and international growth rates and quarter-to-quarter rebounds in international sales volume resulting from the summer seasonality impact. Again, the dollar amount of this rebound will be greater than in the past due to sales being on a direct basis.

Gross margin expectations continue to be 79% to 81% in the third and fourth quarter, as we expect to hold our pricing and product cost at current levels, with some variation allowed for in currency and channel mix.

With respect to operating expenses, while we are revising our guidance to $17.8 million to $18.3 million for the third quarter, and $79 million to $80 million for the full-year, during the first quarter conference call, we told you that it was our intention to conduct a review of our expenses, with the belief that we could find reductions that would allow us to offset the unfavorable impact of interest rates, and the first quarter Conceptus SAS inventory adjustment, and as a result we lowered our total year operating expense guidance to $76 million to $77 million.

After completing that review, we have decided that it would not be prudent for the long-term potential of the business to make those reductions, even though it causes us to lower our total year net income guidance.

The third quarter net income is expected to be between $2 million and $2.5 million or $0.06 to $0.08 per share on a weighted average shares outstanding, up 32.5 million shares. Full-year net income is expected to be between $500,000 and $2 million or $0.02 cents to $0.06 per share on weighted average shares outstanding of 32.3 million.

In terms of earnings per share, achieving profitability will mean a couple of different things for us. First, once the domestic entity becomes profitable on a year-to-date basis, which we expect will happen in the fourth quarter, we will begin recording a tax provision for U.S. alternative minimum tax of approximately 11% to 12% of pre-tax income in addition of the tax provision for international profitability we are currently recording.

Also in our first quarter net income, our fully diluted share count will include the dilutive effect of approximately 2 million shares in Employee Stock Awards which it had not in the past, as it would have been anti-dilutive when we were in a net loss position. We had made no specific allowance for a currency gain or loss.

One final remark before I turn the call back over to Mark. With regards to our position in auction rate securities, we are continuing to hold $48.5 million or AAA rated student loan back securities, for which there have been no auctions for the better part of six months.

We updated our valuation of these securities in the second quarter, and have provided an additional reserve of approximately $300,000 on these investments due to the lack of liquidity. The cumulative reserve now stands at approximately $2.8 million or 5.8%. This reserve is considered temporary, and therefore does not impact our income statement.

Although time will tell what the eventual liquidity outcome will be for the issues we hold, we are increasingly encouraged by recent events of banks re-acquiring auction rate securities at par, including UBS, which acts as our investment adviser, as well as remarks made by the U.S. Treasury Secretary and the Head of the Federal Reserve regarding the intentions of the government to in helping resolve the liquidity situation for state student loan lending agencies that are unable to provide loans to students entering college in the fall.

As I said last quarter, if over the course of the next several months liquidity has not been restored for these securities, there is a possibility that an impairment charge could be considered other than temporary and therefore, would impact the income statement although we currently view that as remote.

Okay, that concludes my remarks. So I'll turn the call back over to Mark.

Mark Sieczkarek

Okay, thanks Greg. I'd like to use the next few minutes to discuss our main thrust for strategically growing our business. First, the DTC or direct-to-consumer campaign, and secondly, physicians transitioning to in-office procedures. I am also going to give you an update on some of the important projects we are working on this year. There is an awful lot going on here, all positive.

First is the direct-to-consumer campaign which started in early February and ran through the middle of June. Let me first remind you that we ran this program because consumer awareness of the Essure was minimal.

Our physicians had not demonstrated the ability to proactively consult with patients about Essure and we wanted to test our ability to develop a scalable media program in the future, in order to grow our market share and ultimately accelerate Essure sales more rapidly.

Now the campaign was designed to reach our primary end customer with multiple touch points. Among these were TV, radio, magazine ads, newspaper, the web, our call center and direct mail. We advertised in eight cities that had been selected based on our hurdle rate penetration of in-office physicians, adequate reimbursement and sales support and the ability to extrapolate appropriately, to predict national results related to various sub-market attributes. The eight cities represented about 5% of the total American population.

Now, as I discuss what we've learned from the direct-to-consumer campaign, I want to caution you that it's still too early to predict sales results from our DTC program, especially when one considers the length of time most women require to make a decision about permanent birth control.

However, to-date there is much evidence that supports optimism, as our experience thus far has exceeded our expectations, and we are cautiously optimistic that such a program can be a growth driver for us in the future, and a strong part of our ability to draw from the 7.5 million families in the U.S. that still depend on temporary birth control methods for permanency.

As we reported to you last quarter, there have been many diagnostic indicators from this program that have been very strong. For example, unique essure.com daily web visits increased to more than 3,000 hits per day. Now, while calls at our call center and direct referral to physicians have decreased since the high point achieved during the time the advertising was running, these metrics continue at rates that are substantially higher than before the advertising campaign aired.

So, although it is very early, there is some evidence of sustainability of effect. Most gratifying is the measured increase of Essure brand awareness among consumers in the tested markets, which has risen 22 percentage points. Now, our ad agency and others tell us that's almost unheard off for a single advertising campaign.

Furthermore, the ads have definitely generated increasing levels of physician interest in Essure. We have taken numerous calls from physicians in these markets that either perform Essure procedures in the hospital and want to transition to the office, or from physicians who do not prefer Essure that now want to be trained. Our signup rate for doctors in these eight cities is almost twice the rate as the rest of the nation.

Both categories of physician reports that they are receiving calls from women who have seen our ads, visited our website, and want to learn more about Essure from their doctor.

We have also heard numerous reports from physicians in these test cities that significant number of procedures they are performing are for women who are not their patients, demonstrating that self-referrals and referrals from other physicians can and do take place.

As a result, we are seeing physicians in growing numbers in these cities reaching out to family and general practitioners to also educate them about Essure's patient benefit and to seek their referrals.

With regards to the impact on net sales from this program, we are tracking our performance in each city against an internal recovery cut requirement. And while the net sales that have resulted so far also exceed our expectations, we again are being cautiously optimistic about the remainder of the year given that the advertising has largely ended.

It certainly remains our belief that a woman educated about the benefits of Essure is not likely to forget, and that the [vital] impact of Essure-treated women telling others about her experience is powerful, and will enable us to continue the growth in these markets in the coming months and years.

Our analysis of the nature, extent and type of direct-to-consumer for our future will depend on what we see in the next six months.

Now switching over, and with respect to the transition of our physician to the office, I think you'd have to agree that, as an organization, we are getting the job done. Kudos to our sales force. Now our sales force has significantly increased in size over the past four years, certainly has matured, stabilized in the increase in skill, in a way that permits the extensive pioneering of this effort.

In the past three years, once realizing the importance of the office based procedures of physicians and payers, but importantly the patients. We have moved nearly 2400 physicians into the office, and increased the percentage of sales in the office channel from 4% to over 50%.

Now, although this transition to the office is very labor intensive as we help doctors establish all the elements that go into a successful experience for the patient, including office staff training, equipment selection and other procedure room infrastructure, physician counseling skills, reimbursement, and referral network building.

It's certainly no surprise that the office is and remains the highest utilization site for us as it remains the most comfortable and satisfying for the patient. It's where also the physician is economically and procedurally the most efficient and it represents the lowest cost site-of-service for the payer.

The office will also prove to be a major competitive advantage for the Essure procedure as competition enters this market. As we believe that we have many distinct advantages as an office procedure, and we'll be moving towards making our product even easier for the physician to use in the office in our next generation offerings.

So, okay, let me provide you an update on several of the other projects we have underwent at the company that we believe will further solidify our business in many areas.

First, we have two important operational projects underway, including the outsource of our distribution function in the U.S. to FedEx, which should happen within the next month. And also validation of the second outsource manufacturing arrangement with Avail Medical, the largest finished goods medical products outsourcer, which will be completed in the fourth quarter of this year. Now both of these projects will diversify risk, add to our capacity, and lower cost for years to come.

In product development, we continue to work on the fourth and fifth generation of the Essure device, which we believe represents exciting steps forward for the procedure, although again, each are likely to require clinical studies and therefore still a ways-off.

Lastly, and very importantly, out of the two regulatory projects we have been pursuing related to the compatibility of Essure with the primary technologies used to perform global endometrial ablation, we have obtained approval from the FDA to modify our label to claim compatibility with thermal ablation which now encompasses both J&J THERMACHOICE, and more recently, the Boston HTA product.

And we are in the process of negotiating final label claim language with the FDA. The NovaSure PMA supplement related to NovaSure compatibility has been submitted to the FDA, and is still under review process.

The significant level of anecdotal evidence or compatibility of Essure would follow-on intrauterine procedures reported virtually at every clinical gynecology meeting has given us confidence that we can eventually demonstrate this sufficiently to the FDA, and we are vigorously pursuing these label changes.

I should point out that on Monday, we actually received notice from our notified body that compatibility with THERMACHOICE, HTA and NovaSure for use in Europe was approved. We of course, hope that since the FDA is looking at the same clinical data, the same approval will be obtained here in the States as well. But I will caution you that this is not always the case.

In closing, let me emphasize that by the end of the year, we will have completed our sixth year in the market with Essure, and we are proud of the strides we have made towards making, moving Essure with its combination of benefits for patients and the healthcare system to the standard of care for permanent birth control.

We expect that our physicians will perform close to 90,000 Essure procedures this year, most of which will be in the clinic or office setting involving nothing more than a simple paracervical block. In order to drive Essure for standard of care, we are pioneering not only a far less invasive alternative to surgical tubal ligation, but we are also fostering a growing interest and expertise in office space hysteroscopy and deepening our physicians practice management capabilities.

We believe these additional efforts with our customers, while time consuming and costly, will sustain procedural growth, market strength and loyalty into the future, whether we see effective competition or not.

As we continue to execute against our goal to move the market from the existing surgical tubal ligation procedure to the non-invasive low cost Essure procedure, we also know there are several other markets that we can address. The surgical tubal ligation market represents, quite frankly, just a low lying fruit.

As I mentioned earlier, there is a market of over 7 million women in the U.S. alone, who have completed their families but have deferred making a decision about permanent birth control, because they did not like the invasive options available to them.

There is also a target market of 400,000 families who each year select the surgical vasectomy for permanent contraception. And there are the huge, as yet untapped markets in the rest of the world, where like the U.S., female sterilization is the number one form of contraception. We will penetrate these markets in the future.

Many other emerging medical technology companies that had gone before have experienced a second period of rapid growth, as new applications marketed through their technologies are identified, and the rest of the world catches up with the west in adoption.

We are optimistic that the conservatively estimated $3 billion global opportunity that Essure represents can fuel such as sustained growth as well, and are building the solid foundation and infrastructure that will support the growth of the business well beyond the $100 million mark in years to come.

So in summary, the highlights for the quarter are first, the strong sequential and year-on-year domestic and foreign sales growth. Secondly, 80% gross margin attainment. Third; very important, $3million in positive cash flow from the quarter.

Fourth, we have continued and consistently powerful physician metrics like continue moving forward. A key piece is also the clinical compatibility with GEA. And lastly, and certainly, a good sign for our future, great DTC, Direct-to-Consumer Diagnostics.

So, in closing, I'd like to say we are well poised for a profitable second half of '08, and revenue and EPS growth in the future as well. So with that commentary, I'll like to open up the call to your questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions)

One moment please for the first question. Your first question comes from Eli Kammerman with Cowen.

Eli Kammerman - Cowen

Thanks very much. Good afternoon.

Mark Sieczkarek

Good afternoon, Eli.

Eli Kammerman - Cowen

First question is, what does your guidance imply for U.S. sales in the third quarter either in dollar terms or percentage growth terms?

Mark Sieczkarek

Well, it's so Eli, the range is $25 million to $26 million. That would leave us with a year-over-year growth of between 52% and 58% in total.

Eli Kammerman - Cowen

And as far as the U.S. component of that, what kind of detail can you provide? And how would you relate it to the impact of the DTC campaign in the third quarter?

Mark Sieczkarek

So we're not going to specifically break out domestic and international, but I did indicate in my remarks that we expect pretty much normal historical growth year-over-year and quarter-to-quarter to exist in the third quarter. Also with regards to the direct-to-consumer program, we've not specifically broken that out in our guidance, but we feel the amount identified in our modeling is appropriately cautious and realistic at the same time.

So with the caveat that bolus of initial advertising has ended and we're not absolutely certain as to what we will expect here in the next six months. We certainly feel that we can attain our sales targets regardless.

Eli Kammerman - Cowen

All right. And my follow-up question is, as far as your SG&A spending, can you give us some rough idea of the magnitude of sales force expansion you see for the full-year in either, head count or percentage terms?

Mark Sieczkarek

We are not going to give out absolute numbers. And as we said at the beginning of this year, our plans for 2008 were not so much expanding the sales territory that carry a quota as it was to expand the in-office specialist that helped our sales force transition a physician from a hospital to the office.

Those people don't have a territory, but they certainly have very important MBOs, and you can see the results of the work that they're doing in our numbers. I will say just as an additional comment that our overall average sales per rap in the second quarter is the highest that has ever been as a result of the maturation of this group, kind of following a rapid rate of growth in the sales force last year.

Eli Kammerman - Cowen

Okay, great. Thanks very much.

Mark Sieczkarek

Thanks, Eli.

Operator

Your next question comes from the line of Amit Hazan of Oppenheimer. Please go ahead with your question.

Michael Tieu - Oppenheimer

Hi. Congratulations on a good quarter, gentlemen. This is actually Michael Tieu calling in for Amit Hazan.

Mark Sieczkarek

Thanks, Michael.

Greg Lichtwardt

Hi, Michael.

Michael Tieu - Oppenheimer

Hi. First question is, just wondering if you could elaborate a little bit more on your DTC plans for the rest of year. How much in total has been spent so far and how much more do you plan to spent for the remainder of this year?

Mark Sieczkarek

Yeah Michael, first, this is Mark. And in terms of the rest of the year, we had a very small maintenance program that was planned and we will continue through with. It's a very small piece if you will that kicks in September, October. That has always been included in the numbers that we have presented to you from the beginning of the year.

And I think that being said, and again its just maintenance what we refer to is maintenance spending and also that will be a test as well in terms of the maintenance and how much maintenance basically is needed. Normally in programs like this, you are talking somewhere in the 10%, 15% of the original spend. But Greg will walk you through I think the original numbers, and how much, and where we spent it to up till now.

Michael Tieu - Oppenheimer

Okay great, that would be great.

Greg Lichtwardt

So, the total cost of the program Michael is around $7.5 million to $8 million. We spent $1.5 million in the fourth quarter of last year. $3.5 million in the first quarter of this year between $2.5 million and $3 million in the second quarter, and as Mark said, we will have a couple of hundred thousand yet to go in between the third and the fourth quarter of this year.

Michael Tieu - Oppenheimer

Okay. So as of now, no additional plans to increase above the $8 million target that you set in the beginning of the year?

Mark Sieczkarek

Absolutely not.

Michael Tieu - Oppenheimer

Okay.

Mark Sieczkarek

As we've always affirmed, again, number one, this was a test program of sorts that took into effect medium mix and spending levels. As we said from the beginning, we are committed to profitability in this business. And as we said even into the future, we can layer in direct-to-consumer even as we go into 2009 and beyond with a good bottom line picture for our shareholders. And we're basically sticking to that story.

I've talked to the market often about the fact that we have one issue in front of us in terms that almost prohibits us from going too fast with DTC and that is in-office usage. And I can tell you that even we tested some of that concept in one of the cities and we're very convinced that in-office needs to be in place before we go and we advertise. Otherwise, we'll have quite frankly, disappointed consumers and irritated doctors as well.

Michael Tieu - Oppenheimer

Got you. And then since you're tracking the net sales impact from the DTC program and its tracking above expectations, how should we quantify these sales as it relates to the rest of the year?

Mark Sieczkarek

I don't know think your need to quantify those sales as it relates for the rest of the year. Again, I think we certainly have put numbers in relative to our guidance we're comfortable with.

As Greg said, within normal course of our business, we are also comfortable in attaining the numbers we've put out on the street. And I think we're all looking, we are very optimistic in terms of what we have seen. But I think we're also being cautious in terms of the next six months and what it brings for us.

Michael Tieu - Oppenheimer

Okay. So with regard to these eight markets that you've already tested with DTC and, are you expecting the growth in terms of interest and procedures to continue at the current rate even though you stop the DTC?

Mark Sieczkarek

Well look at it this way Mike, I mean, there are certain things that once you've hit a market and as I mentioned to you before, we've driven our awareness up to 30% in overall in these eight markets which is pretty incredible for basically almost starting at zero.

You can talk to add people about that and they'll tell you the same thing. That doesn't just go away number one. Number two, the incremental increase that we've seen in doctors and in patients going outside their normal scheme of going directly to their doctor and going to a referral doctor that doesn't just go away either.

And then I think on top of that you are going to have the viral impact which we talked about a little bit. Because, these people have these procedures they are thrilled with them, they are talking about as they are enthusiastic about them, their doctors become more enthusiastic as well, and more comfortable.

So, those things just don't go away and there is a long lasting effect that we're anticipating. The major league question for all of us is going to be how much more market share are we going to drive? And ultimately, how many more sales are we going to drive as a result of that?

Michael Tieu - Oppenheimer

Okay. And I just have last question here. So we are tracking other modalities as well and as I have been inspired strong U.S. sales results and may peer view papers we're starting to see Marina gained more solid traction as alternative to permanent birth control. I was wondering what you guys are seeing in that market?

Mark Sieczkarek

Well you know it's very interesting. We've talked about Marina often. Even with you guys, and I think I have mentioned many teams before, you look at IUDs in the rest of the world, they populate, they make up about 20% market share of the rest of the world and the state it was low single-digits for years and that kind of (inaudible) issue.

Michael Tieu - Oppenheimer

Right.

Mark Sieczkarek

What you are seeing lately is simply Marina picking up share and by the way, a lot of it has to do with they'll tell you from their direct-to-consumer program. And at number one, I think where they are picking it from is certainly from that temporary side of it.

But just keep this in mind, a person that wants permanency doesn't necessarily want Marina, and I think some of the side effects have been fairly well documented, you can go to the web and see a lot of stories about issues with Marina.

We look at Marina as an opportunity, the average person wears a Marina about three years and in the states, at least last year about 75,000 women came out of Marina, the next logical step in the continue of birth control is obviously permanency.

The other side of that is, doctors for years, really, they try to keep people away from permanency and Marina is a good alternative to that. And those people will always look for the best alternative, if they are hesitant about permanency.

So I think ultimately the fact that they're out there creating more education and we are as well. And I can tell you, if you go to the web and strike on Essure, you can end up seeing a page or something about Marina, and likewise if you go to Marina, you can end up seeing something about Essure, and then it's up to the consumer to make the best choice.

And I think that will continue to happen, and as I said in my prepared remarks, we have 7.5 million families who are sitting basically nimble. They have made their decision that the family is done, and up to now have not chosen anything permanent.

Obviously, there is a bunch of IUD wearers in that category, and will continue to be. But I think by letting them know that a non-invasive method is available, i.e., Essure, then we will also extract from that group of people as well. So this goes beyond two moles and worrying about Marina being a competitive threat. I think as we both educate the marketplace, we're both going to benefit as a result.

Michael Tieu - Oppenheimer

Okay. Well, thank you very much for answering my questions. I'll jump back into the queue.

Mark Sieczkarek

Okay. Thank you.

Operator

Your next question comes from the line of Jonathan Block with SunTrust Robinson.

Jonathan Block - SunTrust Robinson

Hi guys, good afternoon.

Greg Lichtwardt

Hi, Jonathan.

Jonathan Block - SunTrust Robinson

Greg, I think this one would be for you. If you could help me out, I think at the end of last quarter, you thought you could make up for the non-cash inventory adjustment, and it seems like now you can't. So, I'm just trying to sort of rectify what changed? Where are you spending again? And is it long-term oriented because it seems like the spend is going up but there is no near-term benefit to revenues?

Mark Sieczkarek

Okay, I'm going to take that one Jonathan because I think it's a strategic question as well. We originally, I think we're back to the number that we said we'd be to at the beginning of the year relative to our expenses. When we did a deeper dive into things that we would potentially cut to make up for the loss in interest income in this FAS adjustment, we started to find that a lot of these were strategic type spends relative to our sales force, relative to some marketing programs that we felt are going to continue to fuel if you will the growth of Essure and felt that would very shortsighted to make those cuts.

I've said this many times that we're in this for the long haul, and I think when we take a look at the impact, certainly we'll still be profitable in the third and fourth quarters and for the full-year. And I think we want to continue also to fuel the growth of this business. So we felt it's in the best interest of everybody that we continue on. And I'll call it rather than spending, I'll call it an investment.

Jonathan Block - SunTrust Robinson

Okay. Thank you. I think maybe to shift gears, your second question relates to direct-to-consumer. Maybe there is a couple of parts, but the first one is, I know it's early, are you seeing any different adoption rates in mostly eight different cities? I think the mix might be different in each of the eight cities.

So again, it is one mix working better than another? And then the other question again relating to direct-to-consumer, which just be, is there a spillover effect? I am guessing if we look out, you don't want to have to spend a dollar for dollar in every sort of city. Is there a spillover either to adjacent markets or even to some markets that you wouldn't expect out of the gate?

Mark Sieczkarek

Yes, good questions. I've been long went into some of the answers, the first one is really quick though, too early to tell. In terms of that mix in the spending, I think time we've got some indication; it's too early to tell. We got to let this run at course. And your second question was?

Jonathan Block - SunTrust Robinson

Spillover over to adjacent markets.

Mark Sieczkarek

Yes, spillover. We've seen spillover effect in every program that we've done including this [C10] up to an including this current DTC program. It's amazing. We've had geographically people many miles away who have had the procedures, a result of DTC who have said they have heard about it through a friend or relative, whatever looked it up and had it done. So yes, we are seeing spillover.

And I think you can equate that probably more to the viral effect, certainly beyond women, I mean doctors are talking about it as well. So yes, there is a spillover. How impactful that will be, only the long-term will tell.

Jonathan Block - SunTrust Robinson

Okay. The last one is real quick. I'm guessing with a very impressive preceptorship numbers, was there a higher number of docs coming from the cities where the spend is going on?

Mark Sieczkarek

Yeah, as I mentioned in my prepared remarks, we've seen almost a doubling effect in terms of the percentage that we're seeing out of the new cities versus the national average.

Jonathan Block - SunTrust Robinson

Okay. Must have missed that. Thanks, guys.

Operator

Your next question comes from the line of Daniel Mallin with WBB Securities.

Daniel Mallin - WBB Securities

Yeah, hi guys. Thanks for taking my questions. I have two quick ones. Going back to the Marina, my concern there is that, the growth here is clearly coming from somewhere, and I estimate something like 700,000 units replaced in 2007.

And if you consider your suggestion of an estimated 700,000 tubals, even a small percentage or so of that 700,000 if it's a decision, because really what you are doing is competing for decisions and if the percentage of people who are going to their physicians are choosing the Marina instead of a tubal, I'm concerned that your overall address of a market there is decreasing.

Can you also clarify for me where the 700,000 number comes from in terms of the total number of tubals performed? How old that is and if you think it is still an accurate reflection of the total in the U.S.?

Mark Sieczkarek

Yeah, that number and Greg can probably fill in on the sources about two years old. It gets updated. There is always a lag to it and it comes out of, I think somewhere from the government. That's one of the issues.

I think going back to your question about, it kind of goes back to my previous answer which is doctors pre-Essure have always discouraged people from permanency, and obviously, then temporary methods including the IUD were a potential place for people to go.

If you look at the continuing of birth control in terms of patches, pills, IUDs and ultimately something more permanent, that's kind of the way it runs. And if you really take a deep dive into the birth control market, including both temporary and permanent, you'll see that the IUD is starting to take share from the things like the pill and the patch, etcetera.

So there is a lot of internal competition there within that temporary market. And certainly as I said before, we don't want a woman getting an Essure if there is any doubt or hesitancy in their mind. And certainly Marina is an alternative to that.

And like I said, the beauty of it is within advertising us, advertising certainly you can see a continuation of advertising relative to pills, etcetera. There is a good education going on and we want people to make the best educated guess that pertains their family. And we think that ultimately as well with a bunch of people coming out of Marinas than have medical side effects with it, that's an opportunity for us. So we welcome their continued education to the public.

Daniel Mallin - WBB Securities

All right. The next question I guess is for Greg. I guess, I was hoping you can clarify in terms of trying to model out the temporary impairment that you took on the auction rates. I'm wondering if you can clarify for me the accounting rules that would otherwise dictate if/and when this temporary impairment would have to be re-characterized and flow through to the income statement?

Is this something that you guys can basically keep on the books as long as is otherwise needed? I know the maturities on these notes goes out fairly long, but are there any specific rules that you are aware of that might cause the impairment to be hitting the income statement sometime over the next year or so?

Greg Lichtwardt

Well Dan, we are going to continue to have a third party value these securities for us. They have very quantified models that they use. And our general feeling is that as long as the impairment stays below 10%, that it is probably of a temporary nature and if rises above 10%, it may be other than temporary. So right now we're kind of a little bit more than halfway to that number in terms of what we have recorded as a reserve.

Having said that though, if you look at the most recent news on this whole topic of providing liquidity to student loan lending agencies, including the big article on Bloomberg of July 10th that talked about how the Department of Treasury and the Department of Education is working together to find market solutions to provide liquidity for these issuers which will then mean liquidity to companies like Conceptus that have invested in these issues. I would say that as long as there is news like that, there is not going to be any kind of a movement to increase the level of impairment that we have taken.

In fact, for the second quarter, as you saw we recorded only an additional 300,000, whereas in the first quarter we took a much bigger reserve of around 2.5 million. So recent news seems to be going in our favor and not against us and I'm at the moment not at all worried about this becoming something that is other than temporary. As I said in my remarks, we consider that to be a very remote type of possibility.

Mark Sieczkarek

And just add to that too, I mean our public accounts are all over this issue and obviously, more than just a Conceptus basis, this is a national issue. And again there are obviously together with us on decision to record the reserve that we have up to this point. But as Greg said, many companies in our situation have gone to third-party people who put value to these notes.

Daniel Mallin - WBB Securities

I guess I'm just a little bit concerned that with the notes paying a lower than money market rate that the incentive for the issuers to be financed which would effectively increase their borrowing cost, and they would probably have to pass that on to students that might serve as an impediment to this liquidity returning to the market?

Mark Sieczkarek

The problem is just as we have no liquidity, the issuers of these securities have no liquidity. They have fundamentally no way to lend now to students entering school in the fall.

And the Department of Education is aware of this. I think there is something like 12 or 15 states that have made it known that they have no way to send students that need money to go to college in the fall. And so it's a dire situation and the government is going to address it, and they're saying they're going to address it.

Daniel Mallin - WBB Securities

Okay, thanks. That's all I have.

Operator

Your next question comes from the line of John Putnam with Dawson James Securities.

John Putnam - Dawson James Securities

Your gross margin was up nicely on a sequential basis. And I am wondering if you could give us a little bit more color as to why that occurred? And also why you're confident that 79% or 80% gross margin is sustainable?

Mark Sieczkarek

Okay. So briefly to recap in the first quarter, I mentioned that we took a write-up to inventory value associated with the acquisition of Conceptus SAS that came out to the income statement over one inventory turn. The dollar amount of that was a little over a million dollars. And that alone depressed our gross margins in the first quarter by about 600 basis points.

So even in the first quarter without that effect, we would have recorded an 80% gross profit margin. If you go back to the end of last year and look at what the trend is then in gross margins from what it was then to the 80% now, that increase can be attributable to the acquisition of Conceptus SAS where our average selling prices have gone from about $200 to a little over $800, number one.

Number two, our favorable currency with the dollar being as weak as it is. Three, cost reductions associated with the launch of our third generation Essure product. And fourth, on volume increased related cost reductions.

John Putnam - Dawson James Securities

Okay. And the two operational initiatives that you talked about, what impact might they have on gross margin going forward?

Mark Sieczkarek

Well they are certainly going to help us maintain what we have, and possibly we can improve. But I think at this point, I would like to have everyone's expectations centered around our range of 79% to 81% for lets say the foreseeable future. And the variation there will be channel mix and foreign currency as to whether where it's the high-end or bottom-end of that range.

John Putnam - Dawson James Securities

Okay, thanks very much.

Operator

Your next question comes from the line of Jason Bedford with Raymond James.

Jason Bedford - Raymond James

Hi, good afternoon. Just a couple of quickies for you. On the revenue line, a pretty nice re-acceleration in U.S. growth. I'm just wondering was that true demand or do you feel it was a little bit of make-up from the first quarter? And then, now that you are through the second quarter, any better explanations as to why you had the weakness in the first quarter?

Mark Sieczkarek

Jason, this is Mark. As I addressed right upfront in terms of our prepared remarks. I think there was some question on the street relative to whether this was a bigger economy issue or as we portrayed it. In talking to our doctors, they told us that there were a lot of deductibles with people putting this off. They have seen that growing now over the past couple of years and we saw more accentuation around this in the first quarter this year.

So I think the answer to your question is, there were people who canceled in the first quarter relative to this deductibility issue and came back in the second quarter. And you know, the way we look at it is obviously, that the deductible for the rest of the year is not an issue for us. But in terms of the growth and how we are seeing it, again, I characterize across the board. It wasn't in any one region. So we feel that we'll continue with that momentum as we head into the last six months of the year.

Jason Bedford - Raymond James

Okay, that's helpful. Just on the cost side of things, it looked like your, the delta in operating expense guidance is about $3 million and I was a little unclear in terms of is it one you are not making the cuts that you had previously planned or two, you are adding more headcount above what you had planned on before?

Mark Sieczkarek

Yeah, it's number one. We're not making the cut. We originally, I think if you look at our original guidance for the year, we are right back there to where we started in terms of operating expenses. And again after revealing these we felt that these were important investments in our future and future growth i.e. especially around the sales and marketing side. So we said that rather than make those cuts, we're going to stay with them.

Jason Bedford - Raymond James

Okay, great. And then just in terms of medical, do you anticipate any impact from that in the second half of the year?

Mark Sieczkarek

Within medical too, we also picked up the family pack which is kind of the portion medical without getting into too deeply which is more for the working part. And a couple of weeks ago, they also approved it. So we're feeling pretty good about medical. We've done some work prior to getting that approval and getting center setup. So we'd anticipate certainly some impact as we go through the rest of the year but I don't think anything is so major that it would impact the numbers that we guided you to.

Jason Bedford - Raymond James

Okay. Thank you.

Operator

Your next question comes from the line of Shawn Fitz with Stephens Incorporated.

Shawn Fitz - Stephens Incorporated

Thanks for taking the question. Mark, just as we think about the markets that you believe have the critical mass to advertise right now, do you have any more than you all have advertised in your pilot? And where do you think that number goes as we look into next year?

Mark Sieczkarek

Well, in terms of cities, Shawn, or in terms of (inaudible)?

Shawn Fitz - Stephens Incorporated

No, in terms of cities. I'm just trying to think about where do you feel like you've got the critical mass in terms of physicians and office mix, the right sales mix and so forth and so on, currently? And then where could that go as we think about 2009?

Mark Sieczkarek

That's under consideration and we're looking at it kind of as we speak. So I don't have a true -- here is the answer Shawn for you on this one. But as I said, it's a gate we have to pass through.

And I would like to think that based on the growth you've seen in office this past year, the fact that our sales reps are motivated by the factor of seeing the success that their counterparts who have had in these eight cities and that they are motivated to go out and get in office doctors as well, because that's one of the key pieces to this program.

Between now and the end of the year, I don't know how many people, how many cities we can have up to speed, but it's not necessarily going to be a large number like 40 or 50, I think probably somewhere between maybe 10 and 15 if I were to sit here today guessing.

And again, as you relate that to where we anticipate to spend next year, I think a lot depends on what we've seen in these last six months relative to return on investment as we have always said we are going to work this into a workable in our P&L that makes sense, continues to drop dollars to the shareholder as well.

Shawn Fitz - Stephens Incorporated

Okay, great Mark. And then I guess, just as a follow-up to that. My recollection was that the magnitude of you advertising in each of your target markets was very intense in terms of the numbers of times. You were kind of touching your target market. Would you need to have that kind of intensity on kind of a long-term ongoing basis for a DTC campaign?

Mark Sieczkarek

Not on an ongoing basis, that's why I made reference to maintaining these cities after the fact. And that your maintenance spend certainly is a lot less than your initial bolus. Coming to your first question, I mean, we hit something like on average 98% of our target audience somewhere between 30 and 50 times during this DTC program.

The question and the answer is still out relative to whether or not we need to go after them that much. And that goes back to the spend testing part of it. Certainly, we're not going to spend any more than we spend because we tested some pretty high levels. But I think the possibility exists that we can go on with a lower spend level and still get to our target effectively.

Shawn Fitz - Stephens Incorporated

Okay. Great. Last question Mark and Greg. Just as we think about your international revenues in the third quarter, do you all expect year-over-year procedure growth international in third quarter?

Greg Lichtwardt

Absolutely. We will have growth.

Shawn Fitz - Stephens Incorporated

So year-over-year growth Greg in international procedures in the third quarter?

Greg Lichtwardt

Yes.

Shawn Fitz - Stephens Incorporated

Okay. Great, guys. Thanks for the time.

Greg Lichtwardt

Thanks, Shawn.

Operator

Due to the allotted time for questions, your final question comes from the line of Thomas Kouchoukos with Northland Securities.

Thomas Kouchoukos - Northland Securities

Hi, guys.

Mark Sieczkarek

Hi, Tom.

Thomas Kouchoukos - Northland Securities

A couple of quick ones. Greg, I think in your comments you mentioned that you expected to do some upside to the international number that was given at the beginning of the year which I think was $20 million. With Q3 down sequentially implies obviously, a pretty big Q4 number. Do you expect that growth to come solely from the markets here today or is there some expansion into new territory that maybe add some incremental dollars there?

Mark Sieczkarek

Well, we are looking at entering a new market that we are not currently in. Although much of that will be contingent upon getting regulatory approvals or reimbursement approvals, so that's a little bit speculative for us.

Really our guidance is based on the business as we know it today, the type of growth rate that we've seen in that business, allowing for the summer seasonality effect. The comments that I made in my remarks is to say that, I think at the beginning of the year we were saying that we would hope to do around $18 million total for international.

Last quarter on the conference call I said, that we expect that number to be probably closer to $20 million. So that's really the upside to the original guidance that I'm referring to. And that remains our outlook for the international business.

Thomas Kouchoukos - Northland Securities

Okay. And then with respect to reimbursement decisions, have you guys made any progress in the UK with the nice committee at all?

Mark Sieczkarek

Our application is in and we anticipate that they'll get through it before the end of the year.

Thomas Kouchoukos - Northland Securities

Okay. And then just one last one, when you are talking about maintenance in the territories that you've already done kind of your bullets, what do you have to do for the rest of this year and into next in terms of keeping the brand fresh in the consumer's minds and the doctor's mind, so their attention doesn't go to whatever the other DTC campaigners go on such as Marina or other products?

How much, I mean, can you quantify it or maybe even qualitatively say what you need to do? I mean is it mailers or is that just a couple of radio ads here or there? How do you structure that and keep it kind of alive in the cities that you've already done?

Mark Sieczkarek

As we go into this maintenance space that's exactly what we're testing. We have various programs exactly as you laid out. Be a TV, radio, direct mail, and we're going to see again from a maintenance perspective what's the most effective. So, once again we're learning as we go.

Thomas Kouchoukos - Northland Securities

Okay. But budget wise you've already laid that out, that's within, I mean you wouldn't have to spend more than what you originally anticipated to get that done?

Mark Sieczkarek

Emphatically, no.

Thomas Kouchoukos - Northland Securities

Okay, great. Thanks, guys.

Operator

That concludes the question portion for tonight's conference call. Do you have any closing remarks?

Mark Sieczkarek

Yeah, I'd just like to thank you all for your excellent questions and appreciate the time you are taking with us on this phone call. Again, we look forward to talking again at the end of the third quarter coming up in the couple of months. And hopefully, we'll be giving you some more good exciting news about our continued growth, both on the top and bottom line. Thanks, again.

Operator

Ladies and gentlemen, that concludes your conference call for today. We thank you for your participation. And ask that you please disconnect your lines at this time.

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Source: Conceptus, Inc. Q2 2008 Earnings Call Transcript
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